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Brazil: A Case Study in Sticky Stagflation

Conclusion: Sticky Stagflation and FX headwinds should continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.


On December 17thof 2010, we published a research note titled, Brazil: A Leading Indicator for the Global Economy?. The conclusion of the note was as follows:


“Looking under the hood of the Brazilian economy and stock market, we see more confirmation of Accelerating Inflation and Slowing Growth on a global basis. Given, we expect both emerging market bonds and equities to underperform as an asset class in 1H11.”


The purpose of flagging this isn’t at all to take a victory lap, as our team full of washed-up collegiate athletes is prone to do. Rather, it is merely to highlight the sheer amount of time that economic fundamentals can remain supportive or unsupportive of certain markets and/or asset classes. Consensus can remain right for longer than we’ve been trained to anticipate.


As institutional investors, we systematically choose to fade visible fundamentals in expectation that whatever news (good or bad) will eventually become priced in before the river card is revealed. This technique is certainly one that has been good to a great deal of investors, but today, Brazil is reminding us all that when growth is slowing and inflation remains sticky, valuation remains no catalyst on the long side. Furthermore, bad news/data can remain a headwind for a lot longer than we are paid to hope.


Brazil Cuts Rates Again

Consistent with our view that the King Dollar will receive a bid from monetary easing across the world – particularly in emerging markets – over the next 3-6 months, Banco Sentral do Brasil lowered the country’s benchmark interest rate, the SELIC, to 11.5%. This is the second cut YTD, after a -50bps reduction at the end of August. After eight hikes worth a cumulative +375bps in the recent tightening cycle, this latest cut is confirmation that the central bank is committed to its newly-adopted policy of lowering the country’s aggregate interest rate burden.


Brazil: A Case Study in Sticky Stagflation - 1


The central bank, which has repeatedly cited slower global growth and the potential for a Eurozone banking/sovereign debt crisis to send the world into another recession, may not be acting solely with the purpose of preemptively buffering Brazil’s economic growth. In recent months, there has been an immense amount of highly-publicized political pressure emanating from President Rousseff and her cabinet upon the central bank, now headed by Rousseff appointee Alexandre Tombini, to lower rates (email us for our expanded thoughts on this topic).


It’s worth highlighting that Brazil, which runs a primary budget surplus of 2-4% of GDP consistently runs a budget deficit in the 2-4% (of GDP) range – meaning that interest costs alone are roughly 4-6% of GDP on average. Rousseff, a self-proclaimed “woman of the people” would much prefer to use the interest expense savings on social spending, in addition to allocating more funds towards the government’s planned infrastructure initiatives over the next 2-4 years (email us for a copy of our Brazil Black Book, where we detail Brazil’s long-term infrastructure needs and plans).


Brazil: A Case Study in Sticky Stagflation - 2


Was It the Right Thing To Do?
Needless to say, with inflation at a six-year high of +7.3% YoY in September and, more importantly, directionally divergent from the central bank’s prior expectations of an August peak, the central bank’s rate cuts are making the more hawkish members of Brazil’s political and investment communities rather nervous. For example, inflation expectations as measured by the central bank’s weekly economist survey expect the country to miss the central bank’s 4.5% (+/- 200bps) inflation target this year for the first time since 2003. Moreover, they are now forecasting consumer prices to rise 5.61% in 2012 – a new YTD high.


Brazil: A Case Study in Sticky Stagflation - 3


We don’t really put much stock in economists or consensus numbers; we do, however, trust in [at least] the conviction behind forecasts when capital is at risk. For a more market-oriented measure of inflation expectations, we turn to the spread between inflation-linked bonds and interest rate futures as a gauge of what investors believe Brazil’s benchmark IPCA CPI index will average in a given period. On the two-year maturity, Brazil’s breakeven spread has widened +30bps since Aug 31st(the date of the previous SELIC cut). As the chart below shows, this contrasts with Brazil’s regional peers such as Chile and Mexico, who saw similar measures decline over that duration.


Brazil: A Case Study in Sticky Stagflation - 4


Uncontained loan growth and the potential for the government to overextend itself in the upcoming fiscal year are also supportive of rising inflation expectations. In the year-to-date through August, domestic credit is growing at an average rate of +20.4% YoY – 340bps higher than the central bank’s upwardly-revised forecast of 17%. Moreover, next year a roughly +14% increase in the country’s minimum wage and [already generous] pension payments – which are already the government’s largest expenditure by line item – should at the very least keep a floor under the demand-pull side of the inflation calculation in Brazil.


Brazil: A Case Study in Sticky Stagflation - 5


Nevertheless, the central bank remains committed to its goal of lowering inflation to the mid-point of its target by year-end 2012 – at least per the rhetoric from Tombini & Co. As highlighted above, it remains to be seen whether or not he’ll be able to meet that expectation by many in and around the Brazilian economy.


Brazil is country with a history of policy blunders, having seen a cumulative 13.3 trillion percent of inflation in the 15 years before the 1994 Real Plan (per Bloomberg). CPI, as measured by the benchmark IPCA index topped +17% on a YoY basis as recently as May ’03, meaning there are a lot people in the country who vividly remember the days of helplessly watching their life savings disappear on a real basis. As such, both the central bank and the government will be under enormous pressure from both markets and voters to make sure their forecasts for CPI prove accurate.


Risk Management Setup

From our perspective, the long and short of the situation in Brazil remains what it has been since we turned bearish on the country in 4Q10. While inflation is likely to have peaked in September according to our models, it is equally as likely to remain elevated and strictly over the intermediate term. Further, we see no reprieve on the growth front until at least a potential bottom in 1Q12E. There’s a lot of risk to manage in between now and then – assuming more recent data (the latest GDP report out is 2Q11) doesn’t push that catalyst farther out in duration.


Moreover, our high-conviction Key Macro Themes of King Dollar and Deflating the Inflation should continue to put downward pressure on the Brazilian real vs. the U.S. Dollar (BRL/USD), as rate cuts will erode demand for Brazilian assets on the margin and falling commodity prices (roughly half of Brazilian exports) will limit both demand for reais in the international marketplace and lower the government’s revenue – potentially eating away at its good-but-not-great fiscal positioning. As an aside, a Senate budget committee recently scored President Rousseff’s 2012 budget and decided that the deficit was likely to come in R$25.6 billion higher than expected due her overstating growth by 50bps (Senate 2012 GDP forecast is at 4.5% vs. Rousseff/Mantega at 5%).


Net-net-net, slowing growth and sticky inflation = Sticky Stagflation and that’s not something we expect many investors to find attractive. Moreover, both monetary and fiscal policy are proving to be incrementally negative for the Brazilian real (BRL/USD is down -12.3% over the last 3mo), another headwind to investing in Brazilian stocks for a U.S. domiciled investor. We expect these fundamentals to continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.


Darius Dale



Brazil: A Case Study in Sticky Stagflation - 6

SP500 Levels, Refreshed: Lines In The Sand

Keith is up in Camden, Maine at the PopTech conference and called in the updated risk management levels for the SP500.  Just like the line around the Greek Parliament in the chart below, the SP500 has TRADE line of support at 1,187.  If you didn’t know this was a macro driven market, now you know.


At Hedgeye, we don’t use crystal balls, but rather utilize our process, models, and good old fashion elbow Greece (pun intended).  Certainly, there is possibility that some maginal conclusion is reached this week in Europe, though the markets appear to be indicating otherwise.  Most notably, perhaps, is the Italian sovereign debt market.  Currently, the Italian 10-year is at 6.02%, which is slighly below the 12-month high of 6.20% reached on August 8th, 2011.   This is also a more than +10% increase in yields in just the last two weeks.


Greek may be marginal, Spain may be marginal, but Italy matters.  On a nominal basis, Italy is the 8thlargest economy in the world.  More importantly, according to the most recent estimates Italy has more than 118% debt-to-GDP, or ~$2.4 trillion in debt outstanding.  Roughly speaking, a +1% move in interest costs equate to +$24 billion in additional interest expenses and and a roughly +2.2% increase in Italy’s budget deficit.  The Italy government bond market apparently doesn’t believe the Eurocrats will find a solution imminently.


As Henry Kissinger said famously years ago:


“When I need to call Europe, who do I call?”


Perhaps we will find out this weekend, though we have our doubts.


We remain short the Euro, via FXE, in the Virtual Portfolio.


Daryl G. Jones

Director of Research


SP500 Levels, Refreshed: Lines In The Sand - SPX


Lesson of the day:  always be wary when a company decides to provide less disclosure.


"While concerns about the U.S. and global economies, as well as weakness in the capital markets, persisted throughout the quarter, Penn National did not experience any significant changes in consumer spending patterns at our facilities." 

- Peter M. Carlino, Chairman and Chief Executive Officer




  • "We took advantage of the dislocation in the capital markets during the third quarter and repurchased 755,517 shares of our Common Stock for approximately $27.1 million."
  • "Our third quarter revenue and EBITDA growth of 11% and 27%, respectively, exceeded guidance again illustrating the value of our operating disciplines, continued success with company-wide initiatives to improve margins and returns on capital deployed over the last year for expanded, acquired and newly-opened facilities...Impressively, fourteen of our fifteen gaming properties generated year-over-year improvements in adjusted EBITDA margins, and twelve of the fifteen increased their adjusted EBITDA."
  • "Hollywood Casino at Kansas Speedway and Hollywood Casino Toledo are expected to open on time in the first quarter of 2012 and second quarter of 2012, respectively, with Hollywood Casino Columbus on track to open in the fourth quarter of 2012."
  • "Reflecting the financial outperformance in the third quarter relative to guidance and assuming a continuation of the consumer trends we have experienced thus far in 2011, we are raising our full year 2011 revenue and adjusted EBITDA guidance to $2.7 billion and $733.8 million, respectively." 
    • 4Q: Net revenues of $671MM and $160MM of Adjusted EBITDA
    • EPS: $2.31 and 4Q of $0.46
    • Preopening: $13.5MM million in 2011, with $7.5MM in 4Q
    • No gains from insurance proceeds related to the Hollywood Casino Tunica flood
    • Operating results of Rosecroft Raceway with a live meet in the second half of 2011
    • D&A: FY $210.4MM and $50.8MM in 4Q
    • Non-cash stock compensation: $24.8MM for 2011, with $6.3MM in 4Q
    • The blended 2011 income tax rate: 37.2%
    • A diluted share count: 107.3MM



  • MA may be a semi-auction process.  PENN will likely be a major contender in that market.
  • In Ohio, it's more of a legislative issue. It's not clear on what the state wishes to do with the racetracks - but they are working hard at coming to an answer and expect an answer from the government soon.
  • Reasons behind going to the regional reporting approach is because they have regional managers overseeing these regions.  Reporting details for 22 properties is becoming cumbersome. Giving that much information from a competitive standpoint is also not in the best interest of shareholders.  
  • They will be opportunistic regarding share buybacks.
  • Corporate overhead was $18.8MM in the 3Q
  • Will not breakout Ohio results when the facilities open - not exactly showing a lot of optimism here
  • Toledo costs are just fine tuning as they get close to opening
  • 3Q cash: $207.8MM, Bank debt: $1.6376BN--$200MM on revolver; 691.2MM on term A debt; 748.1MM on term B debt; Capital leases of 3.3MM; contracted work of 1.9MM; total debt: 1967.8MM
  • $73.6MM of project capex and total capex $96.2MM.  Kansas Speedway Capex - their portion was $20.2MM
  • Opportunities in Asia are limited but they are a constant presence there now. They are looking for modest size projects - not Singapore size. Won't be leaping off of any cliffs.
  • What was $2.7MM of other income?
    • Currency translation gain ($2.9MM of currency)
  • Pre-opening is included in the various regions
  • Saw a slight increase in their non-rated activity and a slight decline in rated activity. 
  • Broadly, they haven't seen any change in early October trends from what they saw in the 3rd quarter
  • In Baton Rouge, they expect PNK to open their project in 3Q12.  Expect a loss of business in their Baton Rouge operation. Are prepared to reduce expenses and protect their profitable business.
  • Spring of 2013 is when they expect Horseshoe Cincinnati on Lawrenceburg. There will be an impact but have the benefit of no smoking ban vs. the competition. Also, there is the difference of suburban location vs. an urban competitor. They will react swiftly to adjust their cost structure.  This is part of the reason that they are taking a regional approach.
  • Street guidance for 2012 - clearly some of the numbers are too optimistic since they do not take into account for cannabalization and ramp.  In 2013, they feel very confident that they will be higher than the highest number.  Expect 2012 to be flattish to 2011.
    • Low and behold, the real reason for less disclosure
    • Believes that many analysts either believe that Ohio will open at full margins and or are not modeling any cannibalization
  • They are not seeing anything unusual in promotional spend out there. Las Vegas locals market is still the most competitive market out there. They are trying to stay out of the fray in Las Vegas though.  Beyond that, regionally, there has been a lot of experience with being over promotional and what that does to your business.
  • Benefit of buyback vs. dividend is that they can't claw back dividends but can also reissue new shares. Dividends are also not tax effective.  Don't count on a dividend anytime soon.
  • They don't believe that their investments are going to yield lower returns. Kent believes that new builds will cannabalize existing properties.  If shareholders don't like their investment opportunities, then they can always sell their shares. Ohio will have a great return on cash - even if you take Lawrenceburg cannibalization into account.
  • Expect that the Baltimore property will get built 
  • Competition from Rivers?
    • Through the 3rd quarter they are not seeing a large impact from Des Plaines.  The Elgin and Hammond license are most impacted as they expected. Not as much impact on Joilet and Aurora feeder markets
  • IL came out strongly against racinos.  The rub is that the measure passed in the House and Senate with minimal majority votes and that without the tracks it may be hard to get the bill passed during the veto session. The government has been unequivocal that it's too expansive to include the tracks. 
  • Ohio tracks - there have been some conversions about the approval and relocation of the tracks, but they expect an answer soon. Cost of relocation? Expects that there will be a premium on the cost of relocation. 
    • Could be well in excess of the $50MM license fee
    • Don't expect to be subject to local referendum but will be subject to local approvals but expect that part to be smooth sailing
  • Normalized tax rate will be roughly 37.5%- 38% 
  • Have $240MM remaining on their stock buyback reauthorization
  • There were no large lobbying expenses in the quarter. They did do a reorganization of their entities to be more tax efficient and will save them $4MM a year of taxes. They did have an obligation to spend some money lobbying in TX - but they weren't successful in getting to a statewide referendum - so there is nothing worth mentioning
  • $50MM in Ohio per license is paid in the quarter before they open
  • They are shifting some players that were rated to non-rated at lower segments of rated play.  Thinks that their share gains may be more that competitors are being more rational on promotion. Losing low end rated play because it's less appealing from a reward standpoint. Seeing less trips at the low end of rated play. 
  • Tick up in promotional allowances: this year includes M and Perryville in the numbers

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Initial jobless claims fell 1k last week to 403k (falling 6k net of the revision to the prior week).  Rolling claims were also at 403k, down 6k from the prior week.  While the rate of improvement has been disappointing, claims have been edging lower over the last five weeks (on a rolling basis).  We remain struck by the fact that the supposedly "technical" factors that affected the 395k number published a few weeks ago have not yet reversed. Overall, this is more positive than we would have expected, especially given market weakness and the lack of fiscal or monetary stimulus.  


Meanwhile, the spread between claims and the S&P remains nearly as wide as it's ever been in the last three years.  If claims move to the level implied by the S&P, that would be roughly 450k.  For reference, a 475k claims level would be consistent with 0% or lower GDP growth.  











2-10 Spread

The 2-10 spread tightened by 2 bps last week as the 10-year yield dropped 5 bps.  






Subsector Performance 

The table below shows the performance of financial subsectors over various durations.




Joshua Steiner, CFA


Allison Kaptur


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Feedlot placements during September fell 1.5 percent to 8 percent YoY based on estimates from three analysts before of the U.S. Department of Agriculture’s next monthly Cattle on Feed update, scheduled for release Oct. 21. Feedlot placements are an indicator of beef supplies in four to eight months.  - The Cattle Net work


Jon Bon Jovi is opening a new charity restaurant, Soul Kitchen, to help fight hunger in New Jersey.


“The buyout market has slowed in the past several months, amid growing economic uncertainty, but that likely won't last. Private equity groups are still sitting on a huge pile of money—$937 billion, to be exact, according to a report this week from the London-based research firm Preqin. And much of that will have to be spent soon” - The Restaurant Finance Monitor


Consumers exposed to social content are significantly more likely to increase their spending and consumption than those who aren't exposed, according to final results from an Ogilvy-ChatThreads study that polled restaurant consumers.  There was a 2-7x greater likelihood of higher spending or consumption depending on the media encountered by the study group. The sales impact was most pervasive when social content was combined with other types of media such as PR, out-of-home and TV. - QSR WEB




Volumes across the board is very low (except GMCR)






Last week Starbucks sustainability director, Jim Hanna told the Guardian that climate change is already affecting coffee farmers.  “What we are really seeing as a company as we look 10, 20, 30 years down the road – if conditions continue as they are – is a potentially significant risk to our supply chain, which is the Arabica coffee bean,” Hanna said. “Even in very well established coffee plantations and farms, we are hearing more and more stories of impacts.” Starbucks is taking a proactive approach to climate change risks. Hanna will be in Washington, D.C. on Friday to speak to members of Congress about climate change and coffee at an event sponsored by the Union of Concerned Scientists (UCS).


THE HBM: GMCR, CAKE - qsreps



Pizza Inn joined the growing throng of U.S. restaurant brands seeking opportunity in China when it opened its inaugural location recently in Hangzhou.

$CAKE downgraded to neutral from positive at Susquehanna


THE HBM: GMCR, CAKE - fsreps




Howard Penney

Managing Director



Rory Green



We knew hold was favorable but didn’t know the mix was unfavorable – the downside of rolling junkets.



Galaxy’s results fell short of our estimates but was in-line with consensus.  While Starworld and Galaxy Macau held higher than normal and we knew that going in, both properties held worse on the rolling junkets and than on the revenue share junkets.  That hurts profitability.  Unfortunately, junket hold mix is impossible to discern unless management tells you. 


For Galaxy Macau, unfavorable mix negatively impacted results by HK$60MM.  For Starworld, we believe that the impact was at least as high unless expenses rose.  So until we get more information on Starworld, we think that if not for unfavorable mix, the Adjusted EBITDA number would have been between HK$1.9-2.0BN – still below our estimate but better than Street’s.





Starworld reported revenues spot in-line with our estimate, but Adjusted EBITDA fell 14% short or HK$123MM from our estimate.  Management stated that the mix of VIP hold was unfavorable in the quarter.  We can only guess that the impact was around HK$100MM unless expenses and or promotional activity shot up sequentially.

  • Gross gaming revenue was HK$16MM (0.3%) above our estimate while net gaming revenue was HK$34MM higher (1%)
    • VIP gross win was in-line with our estimate
    • Rebate/commission rate was 45% or 1.46%, slightly lower than what we had estimated
    • Mass win was right in-line with our estimate.  Drop was a bit light but hold was better.
    • Slot win was HK$6MM lower than our estimate due to lower handle and a slightly lower win rate
  • Reported hold of 3.2% was obviously higher than theoretical – however, everyone knew that going into the quarter (especially the HK analysts) and knowing that the mix was unfavorable makes analyzing the impact of normalized hold on the quarter moot. 
  • Implied fixed expenses came in HK$142MM higher than we estimated at HK$517MM vs. estimated fixed expenses of $330MM last quarter and $1,325MM in 2010.  We can only guess that the majority of this increase is due to unfavorable hold mix.

Galaxy Macau reported revenue that was 2% below our estimate and EBITDA that was 18% lower.  Adjusted for unfavorable mix, Adjusted property EBITDA would have been HK$1,030MM vs. our estimate of HK$1,188MM.  The fixed operating expenses at the property were much higher than they appeared to be in 2Q11.

  • Gross win was 3% lower than we estimated due to lower direct play levels.  In the first quarter of operations, direct play was about 4% at GM. This quarter, there was less than 1% direct play at the property.
    • The rebate/commission rate was 40.3% or 1.2% - lower than the all in rate we estimated (note that this doesn’t include comped non-gaming revenues)
    • Mass revenues were in-line with our estimates although drop was lower and hold was better
    • Slot revenues were 9% higher due to better handle
  • Net non-gaming revenue was HK$39MM lower than we estimated
  • Fixed expenses were HK$125MM higher than we estimated

Other stuff:

  • City Clubs changed their reporting to just fee income so going forward, revenue and EBITDA will be the same.  City Club EBITDA was HK$5.5MM lower than we estimated due to lower volume and low hold as we had noted.
  • Construction materials EBITDA and revenue was a lot better than we expected.  We have no special edge here.

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